In Buffett’s 2000 shareholder letter (all the content in italics in this article is from his 2000 shareholder letter), he mentioned several CEOs of US listed companies in their financial statements. Very unreasonable accounting practices: especially EBITDA and financial forecasts.
Readers are suggested to refer to a blog post I wrote before: “Unreasonable Accounting Techniques in Financial Statements”
Against the use of EBITDA
When Charlie and I read reports, we have no interest in pictures of personnel, plants or products. References to EBITDA make us shudder — does management think the tooth fairy pays for capital expenditures? We’re very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something. And we don’t want to read messages that a public relations department or consultant has turned out. Instead, we expect a company’s CEO to explain in his or her own words what’s happening.
No selectively information disclosure
We applaud the work that Arthur Levitt, Jr., until recently Chairman of the SEC, has done in cracking down on the corporate practice of “selective disclosure” that had spread like cancer in recent years. Indeed, it had become virtually standard practice for major corporations to “guide” analysts or large holders to earnings expectations that were intended either to be on the nose or a tiny bit below what the company truly expected to earn.
Through the selectively dispersed hints, winks and nods that companies engaged in, speculatively-minded institutions and advisors were given an information edge over investment-oriented individuals. This was corrupt behavior, unfortunately embraced by both Wall Street and corporate America.
Thanks to Chairman Levitt, whose general efforts on behalf of investors were both tireless and effective, corporations are now required to treat all of their owners equally. The fact that this reform came about because of coercion rather than conscience should be a matter of shame for CEOs and their investor relations departments.
No one can predict the future
People are powerless against the unknown
I mentioned in my previous blog post “Information investors need should be important and knowable“:
Marks shared that he dined with Buffett a year ago. During the dinner, Marks said that Buffett raised the crux of the problem with forecasting: “Everyone is focused on what’s ‘unknowable’.” Regarding the unknowable, Buffett’s view is: people is powerless. This is actually exactly the same view as Keynes, who said: “We simply don’t know.”
Financial forecasts is inappropriate
One further thought while I’m on my soapbox: Charlie and I think it is both deceptive and dangerous for CEOs to predict growth rates for their companies. They are, of course, frequently egged on to do so by both analysts and their own investor relations departments. They should resist, however, because too often these predictions lead to trouble.
It’s fine for a CEO to have his own internal goals and, in our view, it’s even appropriate for the CEO to publicly express some hopes about the future, if these expectations are accompanied by sensible caveats. But for a major corporation to predict that its per-share earnings will grow over the long term at, say, 15% annually is to court trouble.
Impossible to achieve in the real world
That’s true because a growth rate of that magnitude can only be maintained by a very small percentage of large businesses. Here’s a test: Examine the record of, say, the 200 highest earning companies from 1970 or 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates. You will find that only a handful have. I would wager you a very significant sum that fewer than 10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings-per-share over the next 20 years.
Note: Please note that Buffett’s original words have three conditions, none of which are indispensable:
- This is data from 2000.
- And Buffett’s sampling range is the 200 most profitable companies in 2000.
- The average annual growth rate for the next 20 years will reach 15%.
If it is now, including all companies listed on the US stock market, the average annual growth rate in 20 years has reached 15%, and of course there are more than 10 companies.
CEO is the root of all problems
Leading to CEO’s corruption
The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more troublesome is the fact that they corrode CEO behavior. Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to “make the numbers.”
These accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require it to engage in further accounting maneuvers that must be even more “heroic.” These can turn fudging into fraud. (More money, it has been noted, has been stolen with the point of a pen than at the point of a gun.)
Be skeptical of an optimistic CEOs
Charlie and I tend to be leery of companies run by CEOs who woo investors with fancy predictions. A few of these managers will prove prophetic ¾ but others will turn out to be congenital optimists, or even charlatans. Unfortunately, it’s not easy for investors to know in advance which species they are dealing with.
Case study
Buffett’s own experience
Buffett is not aimless, or talking on paper, and he does have a prescient vision. When the CEO of Freddie Mac (ticker: FMCC) began to make a forecast of future revenue, he sold all the shares of Freddie Mac. Later, something happened to Freddie Mac, and the financial report fraud was investigated by the US Securities and Exchange Commission (SEC); at this time, the media realized that Buffett had reminded everyone a long time ago.
Do not agree with Freddie Mac’s practice
In 1988, Buffett said in a letter to shareholders,
In 1988 we made major purchases of Federal Home Loan Mortgage Pfd. (“Freddie Mac”) and Coca Cola. We expect to hold these securities for a long time. In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.
Buffett bought Freddie Mac shares at an average price of $4 (after stock split adjustment), which accounted for about 9% of his total share capital. He believed that Fannie Mae’s price was “ridiculously cheap.” Xia’s investment in Freddie Mac has doubled 12 times.
The final result
Fortunately, Buffett later changed his mind. In 2000, when Freddie Mac’s performance reached its peak and earnings per share were at the highest level in history, Buffett had an early insight into the abnormality, and almost liquidated all Freddie Mac and Fannie Mae stocks, reducing his shares from 8.6% in 1999 to 0.3%.
Former Fannie Mae regulator Armando Falcon Jr. told the FCIC, “Fannie began the last decade with an ambitious goal—double earnings in 5 years to $6.46 [per share].“
In 2010, in the aftermath of the financial crisis, Buffett told the Financial Crisis Inquiry Committee that he had already had “concerns” about the management of the two companies.
I didn’t know that they were not going to be good investments. But I was concerned about management at both Freddie Mac and Fannie Mae. They were trying, and proclaimed that they could, increase earnings per share at some low double-digit range. And any time a large financial institution starts promising regular earnings increases, you’re going to have trouble. If people are thinking that way, they are going to do things — in accounting but also in operations — that I would regard as unsound. So I just decided to get out.
Although Buffett did not sell at the peak of Fannie Mae’s stock price (close to 70 US dollars), his clearance price was between 40-50 US dollars, but we still have to admire Buffett’s ability to predict.
About Freddie Mac and Fannie Mae
About Freddie Mac and Fannie Mae (ticker: FNMA) and these two special companies, please refer to my book “The Rules of Super Growth Stocks Investing” in subsections 2-3, pages 099-100.
Munger thinks EBIDTA is nonsense
Charlie Munger asked investors to be careful of “nonsense jargon” in the investment world. In the financial world, be careful of “nonsense.” Munger once quipped, “Every time you saw that word (adjusted EBITDA), you just substituted the phrase with ‘bullshit earnings”. In other words, as an investor, you should pay attention to the management of the company and beware of their nonsense to deceive investors.
Related book
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- “Information investors need should be important and knowable“
- “Focus on company performance rather than market“
- “Investors should not trust forecasts“
- “Unreasonable accounting practices in financial statements“
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